Introduction: Understanding stagflation

Stagflation is an economic condition in which a country experiences persistent inflation, weak economic growth and a deteriorating labour market at the same time. It is considered one of the more difficult economic situations to manage because the problems involved can reinforce one another, while the policies used to address one problem can make another worse.

The term stagflation is formed by combining the words stagnation and inflation. Stagnation refers to an economy that is growing very slowly or barely growing at all. Inflation refers to a sustained increase in the general price of goods and services over time. When these conditions occur together, households can face rising living costs while the economy creates fewer opportunities for improving their financial position.

For example, a household can be in a situation where groceries, electricity, petrol and rent become increasingly expensive, but wages barely increase. At the same time, the employer becomes reluctant to hire additional workers, businesses start cutting costs, and finding a better-paying job becomes more difficult. The household is spending more to maintain its existing lifestyle while becoming less confident about its future income.

This is the central problem of stagflation. People experience the financial pressure of inflation while also facing the economic insecurity associated with stagnation.

Stagflation is particularly concerning because a healthy economy would ideally provide relatively stable prices, sustainable economic growth, rising productivity and employment opportunities. During stagflation, these objectives become much harder to achieve together.

The three defining characteristics of stagflation

Inflation remains high

Inflation is the rate at which the general price level rises over time. When inflation is high, households need more money to purchase the same goods and services they previously bought for less.

For example, suppose a household spends $200 a week on groceries. If the cost of its usual shopping basket increases by 5%, the same basket costs $210. The household needs an additional $10 each week to maintain the same purchasing pattern.

The problem becomes more serious when the prices of essential items such as food, housing, electricity and transport rise faster than household incomes. People may respond by reducing discretionary spending, using savings or borrowing more to cover ordinary expenses.

Inflation does not have to mean that prices rise at an accelerating rate every month. Even a stable but persistently high inflation rate can create considerable financial pressure because prices continue increasing.

It is also important to distinguish inflation from the price level itself. If inflation falls from 6% to 3%, prices generally continue rising, but at a slower rate. They do not automatically return to their previous levels.

Economic growth stagnates

The second characteristic is weak economic growth. Economic growth is commonly measured by changes in real gross domestic product, or GDP, which represents the value of goods and services produced after adjusting for inflation.

When an economy stagnates, businesses may struggle to increase sales, investment may weaken, consumers may become more cautious, and productivity growth may remain poor.

Weak growth does not necessarily mean that GDP is falling. An economy can continue expanding but still experience stagnation-like conditions if growth is persistently sluggish relative to its potential. Economists therefore consider the broader pattern of economic activity rather than relying on a single quarter of GDP data.

Population growth also matters. Total GDP can increase while GDP per capita, which measures output relative to population, remains flat or declines. This can help explain why a country appears to be growing economically even though many people do not feel better off.

The labour market deteriorates

The third characteristic is a weakening employment market. Businesses experiencing high costs and weak demand may become reluctant to recruit new workers, reduce employees’ hours or make redundancies.

Unemployment can increase, and workers may find it harder to move into better-paying jobs. Even people who remain employed may experience limited wage growth or feel less confident about asking for higher salaries.

This can further weaken the economy. When households become worried about job security, they tend to postpone major purchases and save more cautiously. Businesses then face weaker demand, potentially leading to further reductions in hiring and investment.

Although rising unemployment is a common feature of stagflation, economists do not require every indicator to deteriorate simultaneously or to reach a particular numerical threshold. The term describes a broader combination of persistent inflation and economic weakness.

Why stagflation is different from ordinary inflation

Inflation can occur in a relatively healthy economy. If demand for goods and services grows faster than businesses can supply them, prices may rise while companies expand production, hire more workers and increase investment.

In that situation, inflation is accompanied by economic growth. Although higher prices can still hurt consumers, a strong labour market and rising incomes may help households absorb some of the increase.

Stagflation is different because inflation persists while economic activity weakens. Businesses face rising costs but may be unable to pass all those costs on to customers. Consumers have less purchasing power, and employers may become more reluctant to hire.

The combination is especially difficult because reducing demand can help lower inflation but may also deepen the economic slowdown. Meanwhile, stimulating the economy to support employment can add to inflationary pressure.

Stagflation is therefore not simply another word for a cost-of-living crisis. A cost-of-living crisis describes the financial pressure households experience, whereas stagflation describes a particular combination of economy-wide conditions.

What causes stagflation?

Supply shocks

One of the most important causes of stagflation is a supply shock. This occurs when an event makes it more expensive or difficult for businesses to produce and deliver goods and services.

Energy is a particularly important example. Oil and gas are used directly in transport, manufacturing, agriculture, electricity generation and many other activities. If energy prices rise sharply, businesses face higher operating costs, which can spread throughout the economy.

Transport companies may increase their freight charges, manufacturers may pay more for production, and farmers may face higher costs for fuel and fertiliser. Some of these increases eventually reach consumers through higher prices.

At the same time, higher costs reduce households’ disposable income and may force businesses to reduce production or investment. Inflation rises while economic activity weakens.

Supply shocks can also result from natural disasters, wars, trade disruptions, shortages of essential materials or major interruptions to international supply chains.

Weak productivity growth

Productivity measures how efficiently an economy turns labour, capital and other resources into goods and services.

When productivity grows strongly, businesses can produce more output from the same resources. This can support sustainable wage increases and improve living standards without necessarily creating excessive inflation.

When productivity growth is weak, businesses may find it harder to absorb higher wages, energy costs and other expenses through efficiency improvements. They may raise prices, reduce investment or limit recruitment.

Weak productivity alone does not automatically cause stagflation. However, when it coincides with persistent cost pressures and slowing demand, it can contribute to a prolonged period of weak growth and elevated inflation.

Currency depreciation

A weaker domestic currency can make imported goods and materials more expensive. For a country such as Australia, this can affect fuel, machinery, electronics, construction materials and components used by businesses.

The effect depends on international prices, exchange-rate movements and how much of the increase businesses pass on to consumers.

If imported inflation occurs while domestic economic growth is weakening, policymakers may face a difficult situation: prices are rising even though demand is not particularly strong.

Persistent inflation expectations

Inflation can become harder to control when households and businesses begin expecting prices to continue rising rapidly.

Businesses may increase prices in anticipation of higher future costs, while workers may seek wage increases to compensate for expected inflation. Wage growth is not inherently inflationary, particularly when supported by productivity improvements. The concern arises when costs and prices repeatedly rise without corresponding improvements in output.

If inflation expectations become entrenched, central banks may need to maintain restrictive interest rates for longer to restore price stability. That can increase pressure on economic growth and employment.

Why stagflation is so difficult to fix

Stagflation creates a dilemma for central banks and governments because their economic objectives can conflict.

Central banks generally use interest rates to influence borrowing, saving, spending and investment. When inflation is too high, raising interest rates can reduce demand and help bring price increases under control.

However, higher interest rates also make mortgages and business loans more expensive. Households may reduce spending, businesses may postpone investment, and employers may become less willing to hire workers.

If the economy is already stagnating, those effects can make the slowdown worse.

Cutting interest rates can support economic activity, but it may also encourage additional borrowing and spending. If inflation is still elevated, that extra demand can make it harder to bring prices down.

Governments face similar trade-offs. Public spending and targeted financial assistance can support households and businesses, but broad stimulus may add to inflationary pressure if demand is already exceeding the economy’s capacity to supply goods and services.

There is no single policy that instantly solves every aspect of stagflation. Policymakers must consider what is causing inflation, how persistent it is, how weak the economy has become and how the labour market is responding.

How stagflation affects ordinary people

Household budgets and purchasing power

The most immediate effect is often a decline in real purchasing power. If wages rise more slowly than the prices of the goods and services a household buys, its income can purchase less than before.

Households may reduce spending on restaurants, entertainment, holidays and other discretionary activities. Those with limited savings can be especially vulnerable because they have fewer resources to absorb unexpected bills.

Even people whose incomes remain stable may feel financially worse off if essential expenses account for a large proportion of their budgets.

Employment and wages

Businesses facing high costs and weak demand may freeze recruitment, reduce hours or make redundancies. Workers may become more cautious about changing jobs because alternative opportunities are harder to find.

Wage growth may also struggle to keep pace with inflation. That can reduce real incomes and weaken consumer demand further.

Housing and borrowing

Stagflation can create uncertainty in housing markets. If inflation remains elevated, interest rates may stay higher than borrowers would prefer. Mortgage repayments can absorb more of household income, while businesses face higher financing costs.

Renters may also face pressure when housing supply is limited and property-related expenses increase.

However, stagflation does not automatically cause house prices to fall. Population growth, housing shortages, credit availability, construction costs and local market conditions all influence prices.

Savings and investments

Inflation reduces the purchasing power of cash when the return on savings is lower than the rate at which prices rise. Higher interest rates may improve returns on some savings products, but they can also reduce the value of certain investments and increase financing costs for businesses.

Investment markets may become more volatile as investors reassess inflation, interest rates, corporate profits and economic growth.

No investment is guaranteed to perform well during stagflation. Outcomes depend on the asset, its valuation, the duration of inflation and the broader economic environment.

Lauren Hua is a private client adviser at Fairmont Equities.

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